How does monetary policy affect the domestic economy?

These are among key questions surrounding the formulation of monetary policy at any given time. The channels through which it affects the domestic economy are collectively called the monetary policy transmission mechanism. Below is a brief description of this process.

As can be seen in Chart 1, monetary policy affects economic activity and inflation through many channels.

The initial effects of monetary policy surface in the financial system. If the Central Bank’s key interest rate is increased, this leads first to an increase in other market interest rates, and conversely, a
reduction in the key rate causes a decline in other interest rates.

The effects on other interest rates vary, however: short-term nominal interest rates generally rise in line with the policy rate, while rates on long-term bonds tend to rise less. This is because long-term rates reflect both the current key interest rate and expectations about how the key rate will develop over the duration of the bond.

To the extent that a Central Bank rate hike leads to an increase in short-term real interest rates, inflation-indexed bond rates should rise as well, followed by the non-indexed and indexed interest rates offered to households and businesses.

An increase in the Central Bank’s key interest rate and other market rates also puts downward pressure on asset prices, causing them either to fall or to rise less than they would have otherwise.

Share prices fall, for instance, as the present value of the future revenue, which the share prices reflect, falls as interest rates rise. Share prices also give way because higher interest rates make bonds a more attractive investment than stocks. In addition, higher interest rates slow down overall economic activity, as is discussed below. This dampens demand for the products companies produce, making the companies less valuable than they would be otherwise.

In the same way, house prices should decline, as new mortgage financing becomes more expensive, reducing demand for housing.

An increase in central bank interest rates should also curb credit institutions’ lending to households and businesses. Lower asset prices erode households’ and businesses’ net worth and shrink credit institutions’ balance sheets and capital. As a result, credit institutions are more reluctant to grant new loans, both because credit risk has increased and because it is more advantageous for them to build up their capital again by cutting back on lending and scaling down their balance sheets.

When the Central Bank raises interest rates, it also affects the exchange rate of the króna, as higher domestic interest rates widen the interest rate differential with other countries. Demand for krónur then grows stronger, causing the exchange rate to rise.

Through the above-described effects on other interest rates and expectations, on asset prices and balance sheets, and on the exchange rate of the króna, monetary policy affects households’ and businesses’ decisions on spending, saving, and investing.

When interest rates rise, it becomes more advantageous to postpone spending decisions, as saving generates better returns. Lending rates rise as well, making it more difficult to finance spending by taking new loans. In addition, the debt service burden on existing loans increases, particularly on variable-rate loans, thereby reducing the amount of money the borrower has for other uses. When asset prices fall in the wake of interest rate hikes, households’ collateral capacity diminishes, making it more difficult for them to take new loans. Higher central bank rates should therefore cause households’ disposable income to shrink and their consumption spending to be weaker than it would be otherwise.

In general, companies’ liquidity position should deteriorate and their financing costs should rise as the policy rate rises. Lower share prices cause companies’ market value to decline relative to the cost of refinancing (the so-called Q ratio falls), making it less favourable to issue new capital to finance new investment. Lower share prices also reduce companies’ access to new credit. Furthermore, a higher exchange rate weakens the competitive position of exporters and firms that compete with imports.

In general, a rise in central bank interest rates should prompt households and businesses to cut back on consumption and investment spending, which in turn will cause aggregate demand in the economy to contract or, alternatively, to grow more slowly than it would otherwise. A rise in the exchange rate also lowers the price of imported goods and services, which shifts demand to a greater extent outside the domestic economy.

In addition to the direct effects on households and businesses, and of equal importance, are indirect effects – so-called second-round effects – which can affect even those households and businesses not subject to the direct impact of the interest rate hike. These second-round effects can surface in various ways. For instance, if household demand drops off, firms not directly affected by the rise in interest rates could nevertheless be forced to scale down their activity; they might abandon planned wage increases or refrain from hiring staff, which could affect households that were not directly affected by the rate hike.

These direct and indirect effects of monetary policy on domestic demand and international trade could cause economic activity to contract or grow more slowly, reducing GDP growth and employment.

Weaker demand for domestic goods and services ultimately eases domestic inflationary pressures and ensures that inflation will remain at target or return to target if it has risen too far. Higher interest rates can also have an impact on inflation by affecting inflation expectations through the expectations channel and through the impact of a higher exchange rate on imported inflation.

The impact of monetary policy on economic activity and inflation generally takes some time to emerge, and it may vary from one period of time to another.

Domestic research indicates that the impact of a 1 percentage point increase in the Central Bank’s key interest rate typically peaks after just over one year, at which time GDP is about 0.6% lower than it would have been otherwise.

The impact on inflation can take even longer to surface. Domestic studies indicate that it typically peaks a full two years later, by which time inflation is about 0.6 percentage points lower than it would have been without the rate hike.

Despite the various unique characteristics of the Icelandic economy, the magnitude and timing of the impact of changes in Central Bank interest rates appear to be similar to those in other countries.